Hi tim I know you usually write about large stock dividend investing but was wondering if you would share how to make small sized stock investments in smaller companies

The process for long-term investing with small-cap stocks is quite similar to how I would approach investing with many of the supersized dividend stocks that I typically discuss here. The rules of successful investing don’t really change depending on the size of the company. Long-term investing always boils down to this: finding a favorable relationship between the current price of a stock, the profits generated now, combined with a prediction about where profits will be 5-10 years from now multiplied by the certainty of that actually happening. Sure, there are other things to take into account, like accelerating dividend payout ratios or changes in the debt carried on the balance sheet, but that’s the basic question I try to answer when evaluating every investment.

If I were trying to look for a small company that would make sense as a long-term investment, I would look for these things: (1) understandable products with room to grow, (2) low debt on the balance sheet and minimal dilution, (3) high levels of insider ownership, and (4) a reasonable valuation.

I mention “understandable products” because many small cap companies have a technology bent, and I usually consider that an automatic disqualifier. That’s the world of fads and speculation, and I’ll let someone else make the money there.

With small companies, you’re almost always dealing with cash-strapped situations. This is problematic because it often means that a company does one of two things. First, they might take on large amounts of debt. That’s not good because they’re racking up large interest commitments and setting themselves up for wipeout in the event that another 2009 year comes around sooner rather than later. And share dilution usually happens when a company wants to grow but doesn’t have enough ongoing profits to make it happen organically. If the growth actually happens, you’re fine. Otherwise, you find yourself in situations where you have to divide up current profits into 12 million pieces instead of 10 million pieces (or whatever the dilution actually turns out to be).

The big-picture problems with high debt loads and ongoing dilution of stock is that it means a company needs to access the credit markets to keep up its business pace. That doesn’t set you up well for recession if a company is at the mercy of creditors at a time when economic conditions turn bad. That’s how you get high interest loans, unduly high dilution, or in worst cases, bankruptcy if there aren’t any willing lenders/new investors.

When you see a Board of Directors or management team with high levels of insider ownership, you know they’re not going to put up with a lot of compensation bologna because it’s their own money that is on the line. Coca-Cola has drawn criticism recently for their lofty executive compensation plan, and that’s because there aren’t a lot of shareholders out there with large ownership stakes that could deter it (the one exception being, of course, Warren Buffett, and it will be interesting to see what he says during the first weekend of May when a shareholder inevitably asks him for his thoughts on it). You want to avoid “monopoly money” syndrome with management teams, and that is why it is useful when the people calling the shots actually own a large percentage of the company.

And lastly, I mention “reasonable valuation.” A lot of fast-growing small companies trade at absurd ranges like 60x current profits, 100x current profits, 250x current profits, or whatever. When future growth is baked into current profits like that, you find yourself getting 10-13% annual returns even if things work out spectacularly as expected, when you could have just created as much wealth by purchasing a giant block of Exxon stock without exposing yourself to the same downside risk.

What’s an example of a company that would have passed all four tests in recent memory? Boston Beer in 2003.

The company sells an easily understandable product: beer. Specically, Sam Adams. They also sell Twisted Tea and Angry Orchard, primarily in Pennsylvania, Oregon, New York, and Ohio.

At the time, the company had essentially no debt, except for some rental lease agreement. It also had $10 million in the bank while making $0.70 per share in earnings and $1.30 per share in cash flow. There were 13.5 million shares outstanding at the time, a figure that hardly budged with the passing of each year.

As for insider ownership, the officers and directors own 36.0% of the common stock. If you’re not good at spotting the BS in financial statements of small companies, then relying on high levels of insider ownership like that is a decent substitute.

And lastly, the company had a reasonable valuation: The company was planning on increasing its production from about 500,000 barrels per year to 2-3 million barrels of beer over the course of the 2003-2013 decade, but it wasn’t priced like it. At the time it was making $0.70 per share in profits, the company was trading at $11 per share. In other words, about 15x profits. And then the company went on to grow at 22% annually, and now you have a situation where the stock has climbed to $234 per share. A $25,000 investment in April 2003 would be worth slightly under half-a-million today.

By the way, none of this is to suggest that Boston Beer is something that should be purchased today. The terms of the investment today are quite different compared to 2003: Boston Beer is now growing at about 14-16% annually, rather than 22% annually. The current valuation is between 45-50x earnings, meaning that investors today would own about one-third of the current profits compared to the level available in 2003. In other words, everybody caught on to what Boston Beer is doing, and now the new investors are going to be looking at 10% or so annual returns going forward if the company keeps growing at its current rate (they’ll get whacked by P/E compression from 45-50x earnings to 20-25x earnings that will inevitably occur over the long term). And, if the company only grows at 5-7% per year for a while, you could be looking at a situation where the common stock would be trading in the $230s five years from now (and you wouldn’t be getting any dividends either unless the Board changes its policies).

Nevertheless, Boston Beer is a good example of what to look for in a small-cap investment. Understandable products being sold. Low debt and minimal stock dilution. High levels of insider ownership. Reasonable valuation. None of those elements individually are indispensable for making a good investment, but if you ever see them come together at once (and you’ll find them again, once the S&P 500 has a 15-20% down year), you take out your checkbook and write the biggest check you can, because excellent rare opportunities deserve impressive commitments of your money when your hours of research lead to that perfect-pitch-down-the-middle moment.

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